Relevance of the Firm's Capital Structure - Assignment Example

Corporate finance If the capital market is efficient there is no need to spend time on setting a particular capital structure and a dividend policy for a listed company. Introduction The capital market is the market for investment funds in the long-term where equity, bonds and other securities are traded. There are a long term primary market for the primary equity issues and a secondary market for those existing shares (www.thefreedictionary.com). Thus it’s clear that capital markets don’t include short term money markets where money is lent and borrowed in the short run through the interaction of the institutional and non-institutional players such as banks, financial houses and individual money lenders. Functional efficiency of the capital market is determined by a number of factors including the government’s regulatory mechanisms. On the other hand capital structure of the firm is defined as the manner in which a company would seek to finance its assets by using a combination of equity and debt or/and some hybrid securities. It’s a long term effort to keep the company going (www.investorwords.com). A company’s capital structure is determined by the manner in which it combines its assets such as between equity capital and debt capital. If the company issues 90% debt and 10% equity by way of ordinary shares then its capital structure is 90% financed by debt and 10% financed by equity (Friedrich, 2007). Assuming that the capital market functions efficiently, there won’t be the need to manipulate this capital structure as advocated under various theories. For example the Modigliani-Miller Theorem suggests that when there are perfectly competitive market conditions, there is no relevance in considering the manner in which the firm’s assets are financed in order to determine its value. Thus even in the absence of a theoretically determined value for the firm, there can be an optimum capital structure. However the most important question is whether perfectly competitive financial markets do exist or not and if they do, under what circumstances and wherefore (Pettit, 2007). If they do exist, the dividend policy of the firm is surely based on these positive outcomes. Analysis The capital market structure of the firm can be examined with reference to a number of theories. The Modigliani-Miller Theorem is the earliest of such theories to consider the relevance of capital structure to determine the value of a firm. In recent times these theoretical constructs have been developed in line with an ever increasing tendency to consider the leverage issue of the company. Leveraging by managers to achieve exclusive personal goals is nothing new. In fact it’s the conflict of interests between the principals or owners (or shareholders) and the agents (or managers) that has thrust the issue of leverage to the fore. In other words the complex issues revolving around capital structure of the firm are basically influenced by this conflict in which managers tend to have more information about the probable outcomes of future investments than shareholders. Thus this information asymmetry leads to a series of other problems. Disagreement between managers’ behavior on the one hand and the shareholders’ behavior on the other gives rise to a series of other related problems, e.g. information asymmetry, agency costs, taxation and bankruptcy costs. Information asymmetry refers to the manager’s ability to control the flow of information in his favor so that the principal or the owner would have less access to information. Agency costs are related to the principal-agent relationship. For example when a principal hires an agent he does so with the intention that the latter would act in conformance with certain rules to bring about what the former wishes. However the motivating factor behind such performance is the monetary compensation such a good salary to the manager. Therefore such behavior on the part of the manager would not be in his best interest. His tendency to deviate from what is expected of him is common among all managers. In order to reduce such negative behavior the manager must be adequately compensated. However the principal does not know what the agent would do to ensure that his own interest prevails. Costs that are associated with this behavior are known as principal-agent costs or the principal-agent problem. Agency costs are divided into three sub-categories. These agency costs occur as a result of principal-agent problem (Damodaran, 2005). (a). Asset substitution effect As and when debt to equity ratio increases managers tend to substitute new assets through new investment thus relatively increasing debt in place of equity. Assuming that projects are riskier, there is still a fairer chance of success against failure thus obliging both debt-holders and share holders to condone such risky investment decisions on the part of managers. Successful investment projects lead to cumulative share holder benefits while unsuccessful ones lead to cumulative debt-holder woes (Fama and French, 1998). However in the long run with new projects rising, the value of the firm is bound to decrease while a net transfer of wealth from debt-holders to share holders is more likely. (b). Underinvestment problem Managers would not hesitate to reject projects with positive Net Present Value (NPV) because they would not be bothered to increase the value of the firm any more than to allow the accrual of benefits associated with riskier debt to debt-holders themselves rather than to share holders. (c). Free cash flow problem Finally there is the problem of free cash flow. In the absence of free cash flow benefits accruing to investors, the manager has a tendency to reduce the value of the firm through prodigal behavior, such as granting bonuses and higher salaries (da Silva, Goergen and Renneboog, 2004). Therefore higher levels of leverage would act as a preventive factor of such behavior and ensure discipline. While these agency costs reduce the level of market perfection, there is no certainty that their ultimate impact would not be reduced in the light of intervening influences such as demand for and supply of debt /equity being regulated through efficient wealth redistribution methods. Next there is the problem of taxes. When corporate taxes are considered the firm is entitled to interest expense deduction which enables it to increase value of its assets (Bohn and Stein, 2009). In other words investment related tax benefits would increase the value of the firm. According to Modigliani and Miller (1963) the tax exemption allows the firm to reduce the leverage-based premium in the cost associated with raising the equity capital. Subsequently Miller (1997) added personal taxes to the equation. According to him individual investors would want a greater benefit by way of pre-tax returns on their investments so that they might not be affected by higher personal tax obligations on their earnings (Schon, 2008). According to Miller when the equilibrium occurs, the individual tax liability will be so greater as to offset any benefits related to the corporate gain. This renders capital structure irrelevant. Next bankruptcy costs are associated with the probable event of the business going bankrupt. Bankruptcy costs are divided into direct and indirect costs. Direct costs include those associated with legal process and deadweight losses. On the other hand indirect costs include sales losses. Thus in the event of bankruptcy greater the probable explicit and implicit costs including those of the cash flow returns, the lower the amount of debt that the business can borrow. Therefore it’s essential now to discuss the various theoretical underpinnings of the optimal capital structure in order to determine how efficiently the capital market would be able to function in the absence of the above mentioned shortcomings such as bankruptcy costs and information asymmetry (Chew, 1997). In addition to the Modigliani-Miller Theorem of the optimal capital structure, there are some highly influential theories. With the help of them it’s possible to discuss how best an efficient capital market can be brought into existence (or not) thus rendering both capital structure and dividend policy of the firm irrelevant. However the extent to which those capital market imperfections can be overcome would determine the degree of perfection of the capital market in a given situation. 1. Modigliani-Miller Theorem Modigliani-Miller Theorem (M&M) occupies a very important place in the determination of relevance or irrelevance of capital structure for the value of the firm. Therefore it’s equally important in examining the efficiency of capital markets. According to M&M the value of a firm depends on its capacity to earn and distribute profits among its shareholders along with the associated risk of assets. In other words the value of the firm has nothing to do with the way in which it makes its investments and distributes dividends. The firm might adopt one or more of the following methods to finance its assets. After all M&M says that it is irrelevant how the firm finances its assets whether by issuing equity or raising debt. Even the dividend policy does not matter. If there were no dividend policy at all still it would be irrelevant. In short M&M is also known as “capital structure irrelevance theorem”. Therefore it’s essential to consider the very basis of M&M in the backdrop of an evolving theoretical framework on the subject and delineate the connected arguments on the relative efficiency of the capital market. The following diagram (Figure 1) shows how bankruptcy theory associated with M&M would impact on the capital structure of the firm (Altman and Hotchkiss, 2005). The firm might borrow and invest, it can issue shares or/and it can reinvest money from its reserves. Whatever it does, its freedom to choose between choices is limited by the very structure of capital. In other words the leverage decisions might interfere with its freedom to have more of one and less of the other even if it were desirable. Despite this limitation according to M&M there is no need for the firm to have a dividend policy. Above all M&M seeks to prove its validity through an example of two firms, one adopting a leverage policy in which the firm borrows money partially (debt) and finances its assets and another adopting an unlevered approach in which it finances its assets only through equity. M&M comes to the conclusion that the value of both the firms would remain the same. Jensen and Meckling (1976) however question the credibility of M&M’s assumption that individual firms make their investment decisions with no regard to capital structure. They cite the asset substitution effect as the basis on which such conclusions cannot be warranted. In other words equity-holders of levered firms can benefit at the expense of debt-holders through manipulating risk when investments have been made. As the above diagram illustrates the actual value of the firm declines as the optimal amount of debt is surpassed at D1. The value of the firm without leverage (Vu) is shown by the flat horizontal arrow. Value of the firm with leverage (VL) is shown by the extended blue arrow and its total value is depicted by taxes, debt and a residual value. For example if an individual investor considers buying shares of the unlevered firm, Vu and thus matches his borrowings to the borrowings of the levered firm, VL, then the returns of both the firms must be the same. As a result the value of the levered firm must be the same as the value of the unlevered firm minus the debt that the levered firm borrows in order to finance its assets. However in this example there are no taxes. In the real world, taxes do exist. Therefore it’s better to consider an example with taxes. This is illustrated by the above diagram with present value of a tax shield on debt. The levered firm stands to gain by way of tax deductions, i.e. it is entitled to compensation of interest related expenses. This means leveraging would help the firm to pay less taxes than those unlevered firms. Thus it brings the argument to the very beginning again. M&M proves that as long as the capital market is efficient in preventing additional costs of borrowing, i.e. other variables remain constant, then leveraging helps the firm to achieve a degree of efficiency but capital structure itself does not determine the value of the firm (Chisholm, 2002). 2. Trade-off theory Trade-off theory is not against the existence of bankruptcy costs. The theory supports debt-financing of assets rather than equity-financing because of the associated tax benefits (Brealey and Myers, 2002). The theory goes onto add the disadvantages also. Its original of the existence of bankruptcy costs entails more of a burden in times of failure because bankruptcy would further encumber the firm with debt. Further there are non-bankruptcy costs also such as trained staff leaving the company and demanding favorable settlement packages. Above all such costs would compel the firm to increase its debt. Thus the marginal benefit associated with original debt-financing would diminish and turn into a marginal cost. Thus the theory essentially focuses on the trade-off between equity and debt. As for a particularly advantageous position of the firm vis-à-vis its competitors, there is very little to be mentioned by way of well-geared capital ratios (Caouette, Altman, Narayanan and Nimmo, 2008). The theory does not necessarily mention about the relevance or irrelevance of capital structure except to support a very high content of debt or leverage. As for the dividend policy of the firm, the theory seems to identify the existence of a dividend policy depending on the degree of leverage. The higher the leverage the higher the after-tax profits for distribution or/and plouhging back into the business. As for the optimum capital structure of the firm the theoretical underpinnings do not elaborate the degree of divergence or convergence between variables (Eckbo, 2008). For example there is no determinate outcome with regard to the relevance or irrelevance of capital structure. Since this theory focuses on agency costs and financial distress of firms, there is some theoretically valid argument attached to its outcomes though. Agency costs apart financial distress arises due to the firm’s failure to meet demands from debtors. If debt holders find out that the firm is unable to meet its obligations, then they would force the firm to declare bankruptcy and go for liquidation. In the first instance there is the direct cost entailed by insolvency. Thus subsequent liquidation process would compel the management to sell assets at distress prices (Coyle, 2000). All this is associated with a particular outcome, viz. value of the firm. Thus the inverse relationship between distress costs and value of the firm could be used as a measure of capital structure but nevertheless capital structure is not determined by the value of the firm. Hence the argument that financial distress like agency costs would not be taken as a conclusive measure to arrive at firm’s value determination decisions is valid enough not to warrant a second look at the irrelevance of capital structure in determining value. Trade-off theory has been criticized by Miller who argues that the relative significance of debt decreases with the personal tax on interest income. Therefore any gains made through leverage are negated through a corresponding rise in personal tax obligations. While Miller’s argument is nothing new there is a very substantial amount of irrelevance of capital structure in determining the value of the firm. In the first place though perfectly competitive conditions might not exist in the capital market and therefore it might not function efficiently as demonstrated above because imperfections such as agency costs and information asymmetry occur, there is the possibility of ensuring functional efficiency through competitive demand and supply measures (Berger, Ofek and Yermack, 1997). This is much rather important than the total dependence on capital structure to determine the firm’s value. 3. Pecking order theory Pecking order theory was developed in response to the relatively weaker arguments of Trade-off theory by Myers and Majluf (1984) and simply states that managers choose their financing sources according to the inherent rule of least effort in which equity-financing is carried out only as a last resort, i.e. after exhausting every possibility of raising debt. Thus according to Myers and Majluf the firm goes by priorities – first, it uses internal reserves, then debt and finally equity capital. In contrast to Trade-off theory, Pecking order theory has a clear advantage in that it adequately captures the negative relationship between the firm’s profitability and debt. According to Pecking order theory this proposition has a number of other advantages. In the first instance, firms attempt to match their ratios of target dividend payment with their investment plans. Secondly such sticky dividend pay-out policies would ensure a constant positive cash flow despite unpredictable profit margins and erratic changes in investment opportunities. However there is no guarantee that the net cash flow would be always greater than the sum total of capital expenditures. Assuming that the firm generates net positive cash flow it would be able to invest it in securities or just use to pay off debt. Either way a constant return on the individual share holder’s investment is ensured. Naturally debt issue gives out a positive message to the financial markets while an equity issue gives out a negative message. Further the cost involved in an equity issue is much higher in comparison to a debt issue. Pecking order theory does not necessarily comment on the value determination of the firm; neither does it discuss irrelevance of the capital structure to value determination. However it adequately explains the circumstances under which the firm raises debt so that the subsequent outcomes focus on the irrelevance of capital structure to the determination of value (Damodaran, 2001). Conclusion A number of other theories have come with a variety of explanations to the relevance/irrelevance of capital structure in determining the value of the firm. However there is very little theoretical analysis of the relevance or the irrelevance of a dividend policy for the firm. Despite these shortcomings both in theory and empirical literature there is a valid hypothesis on the subject of efficient functioning of capital markets as the harbinger of an end to capital structure and its related theories in determining the value of the firm and acting as a deciding factor (Chew, 2000). Market imperfections include information asymmetry, agency costs, taxation problems and bankruptcy costs. Information asymmetry is primarily attributed to the conflict of interests between the principals and agents. In other words it’s based on the principal-agent problem. In order to ensure an efficiently functioning capital market this imperfection has to be removed thus rendering the significance of capital structure in determining the value of the firm irrelevant. Secondly agency costs constitute another market imperfection. Agency costs are divided into three sub-categories. They are asset substitution effect, underinvestment problem and free cash flow problem. Asset substitution effect occurs when managers behave in such a manner to substitute debt in place of equity through new and riskier investments. Under investment problem occurs when managers act in a manner such as to reject projects with positive NPV because they are less likely to tolerate an increase in the value of the firm, thus indirectly conniving to transfer the benefits to debt-holders. Free cash flow problem occurs when managers tend to be overgenerous with distribution of benefits to investors. Agency costs might not be totally wiped out unless the principal-agent problem is solved. Finally there is the problem of bankruptcy costs. They occur in situations like the company going bankrupt, e.g. legal costs and payments to those affected (Agrawal and Mandelker, 1987). Taxation also entails similar problems which cause the functioning of capital markets to be inefficient. However the capital structure theories have come out with some partially successful alternatives completely or partly disregarding the relevance of capital structure in determining the value of the firm. Thus in conclusion this writer holds the view that despite imperfections in competitive markets for finance, there are still possibilities to develop efficient capital markets through substantial promotion of free market forces. Thus capital structure of the firm and therefore a particular dividend policy are both irrelevant. REFERENCES 1. Agrawal, A., Mandelker, G. 1987, Managerial incentives and corporate investment and financing decisions, The Journal of Finance, Vol. 42, pp.823-837. 2. Altman, E.I. and Hotchkiss, E. 2005, Corporate Financial Distress and Bankruptcy: Predict and Avoid Bankruptcy, Analyze and Invest in Distressed Debt, John Wiley & Sons, Inc, New Jersey. 3. 3100 Bankruptcy and Capital Structure Theory, 2009, from, www.scribd.com 4. 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(Ed.), 2008, Tax and Corporate Governance (MPI Studies on Intellectual Property, Competition and Tax Law), Springer, New York. 25. Scott, D.L. 2003, Capital Market, from, www.thefreedicictionary.com. Read More